3 Top Retiree Tax-Planning Mistakes

You’ve submitted tax forms for many years. How difficult can it be to submit them in retirement? It isn’t difficult – as long as you take into account basic changes that occur in retirement and the corresponding tax challenges.

Fortunately, you can learn from those who have retired before you. We are happy to pass along three of the top mistakes that retirees tend to make, so that you can plan now to avoid them.

1. Incorrectly Rolling Over a Retirement Account – Upon retirement, you have the option of rolling over your 401(k) into an IRA to maintain the balance – but you must be careful about how you do so.

Make sure that the funds are assigned directly from the 401(k) to the IRA. If the funds pass through you, it’s as if you cashed out the 401(k) to start a new IRA. Your former employer will withhold taxes and the remaining 401(k) distribution will be considered taxable income. By depositing the funds into a different retirement account within 60 days, you can still avoid a tax hit – but you will have to also deposit the same amount of money that was withheld for taxes via another source. Regardless of where you plan to retire, the number one factor in ensuring that you can retire on your terms is your 401(k). Make sure that your 401(k) is maximizing its potential with this free analysis that checks your fees, fund mix, and other factors to help you hit your retirement goals.

2. Mismanaging Distributions – Generally, you can start taking distributions that are free from penalty from your 401(k) or traditional IRA once you reach age 59-1/2. Once you reach age 70-1/2, you must start taking out required minimum distributions (RMD) from your account to avoid paying a stiff penalty (50% of the required amount that you didn’t withdraw).

Alternately, Roth IRAs are different since they are established using post-tax dollars. You may take out Roth IRA distributions at any time without penalty once the account has been established for at least five years.

By sketching out a rough long-term plan of your retirement income and when each source kicks in (for example, when you plan to claim Social Security benefits), you can keep your distribution proportionate to your needs and not suddenly thrust yourself into a higher tax bracket with an unexpected distribution. You can get your estimated Social Security benefit amounts anytime online by establishing a My Social Security account.

3. Misunderstanding Taxable Income and Withholding – As your income sources and amounts change, so do your tax liabilities and options. It’s important to know which sources of income are taxable so you know how much money to withhold. Otherwise, you may face an unpleasant tax bill and potential penalties for underpayment.

While most Roth IRA distributions are non-taxable, regular IRA and 401(k) distributions are taxed at your normal income rate, as is all income from your non-retirement sources, including capital gains, interest, and dividends. Any work you perform in retirement as an independent contractor will require extra withholding from some source to balance out the tax burden.

At higher total income levels, up to 85% of your Social Security benefits may be taxed as well. To find out, you’ll need to calculate a “combined income” to see if you meet income thresholds. IRS Publication 915 can guide you through the process.

While these three tax-planning mistakes can put a dent in your retirement plans, they are by no means the only ones. It’s important to do a comprehensive review of your finances heading into retirement and try to minimize your tax burden as much as possible.

If you need help assessing how your tax situation will change in retirement, seek the help of a qualified financial professional with experience in the field. Don’t let your dreams of a pleasant retirement derail you from the preparation that it takes to get there.